Mutual Fund Flows and the Supply of Capital in Municipal Financing

This paper identifies the impact of fluctuations in the supply of capital from mutual funds on municipal bond financing and makes three contributions to the literature. First, we develop an identification strategy based on the Morningstar rating methodology at the moment that funds reach 5 years in operation. This approach isolates supply-side effects that are orthogonal to both fund and issuer fundamentals and can be applied in a broad range of settings. Second, we show that exogeneous fund flows lead to more municipal bond issuances and raise bond prices, but only when funds, issuers, and underwriters are connected through existing relationships. This result highlights the role of relationship lending in the context of municipal bond financing. Third, our results suggest that municipal bond issuers exploit favorable financing conditions to issue bonds with shorter delays and lower transaction costs, such as non-general-obligation bonds that require no voter approval and non-green bonds. These frictions can limit the impact of capital-supply shocks on municipal financing.